Contrary to popular belief, the greatest obstacles to investing successfully aren’t the innate risks and uncertainties found within the markets, nor dishonest or less than competent advisors, or even high fees. The reason why so many investors underperform or fail is due to a pattern of consistently bad decision making.
In 1979, two psychologists, Daniel Kahneman and Amos Tversky, published a paper in prestigious journal Econometrica, titled Prospect Theory: An Analysis of Decision Making under Risk. So influential was this paper that Kahneman won the 2002 Nobel Prize in Economics for his work on the subject (Sadly Tversky died of cancer in 1996, and the Nobel Committee does not award posthumously).
In essence, Prospect Theory pertains to how we behave during times of uncertainty and how we manage risks. Their findings suggest we tend to limit our profits but are more open ended with our losses. We do the opposite of what the old trading axiom admonishes us to do: let our profits run and cut our losses short. According to Prospect Theory, the sad truth is that many of us are pre-programmed to take large losses and small profits, a sure recipe for investing disaster.
As an example imagine you bought 100 shares of Apple (AAPL) stock at $50 and it trades up to $70 a share.
As it rises you’re probably feeling a sense of satisfaction at your stocking picking prowess, and also mentally accounting for your $2,000 profit.
You may be pondering what your profits can buy – say a new 65-inch flat screen television, or perhaps a vacation to Paris.
However, as the market invariably corrects, and your AAPL stock trades lower, you see a $2,000 gain slowly turning into a $1,700 then $1,300 profit. Mentally you’re dismayed that your 65-inch flat screen has shrunk to a 55-inch version, and your trip to Paris is quickly degenerating into a trip to Gozo.
If you’re a typical investor, your gut reaction is to not lose out on the equivalent of at least a 55-inch flat screen, so you take profits. After all you rationalise, a $1,300 profit is better than nothing.
Let’s say after you sold your AAPL you bought 100 shares of Eastman Kodak (EK) the film processing company at $45 a share. Unlike AAPL, EK plunges to $35 and you’re now losing $1,000. As you contemplate your bad fortunate, you’re undoubtedly rationalising it as a paper loss, which won’t become real till you sell. You decide to hang on, anticipating an exit as EK trades back up to $45 – your breakeven point.
However, the stock plunges further, and now at $25 a share, the loss of $2,000 is too large to fathom. If you wouldn’t accept a $1,000 loss, why would you accept a $2,000 loss, so you stay with your paper loss hoping EK will recover.
According to Prospect Theory, we have an innate compulsion to not want to gamble with profits, but to gamble or take risks with losses. We internally rationalise taking profits before they disappear as we did with AAPL, but we take chances with losses hoping they will reverse as we did with EK. Very often instead of letting profits run and cutting losses short, we lets losses run (EK) and cut profits short (AAPL) .
The astute investor would have allowed his AAPL profits to run, and cut his EK losses short. Risk management is essential to investing success, and all investors need a pre-determined loss level, which is not to be exceeded. By the way, Apple stock is today trading as a pre-split level of over $700 a share, and EK filed for bankruptcy in 2012 effectively trading at zero.
Understanding Prospect Theory and compensating for our irrational tendencies to gamble with losses, but to limit gains is essential to investing success.
Joseph Portelli is the managing director of FMG (Malta) Ltd.